Climate risks ‘financially material’ to fiduciary duty Law Committee tells trustees

As the financial risks of global warming are mounting, pension fund trustees should consider climate change in their investment decision making, the UK's Financial Markets Law Committee (FMLC) has said, weighing in on the debate whether considering ESG factors could pose a breach of fiduciary duty.

In a paper aimed at trustees for UK pension funds, the FMLC, a body which provides legal advice to financial market stakeholders,  tackles the perception that considering climate risks as part of investment decisions was in breach of trustees fiduciary duties. 

The Law Commission, a statutory body set up to review UK legislation, currently distinguishes between financial and non-financial factors that could influence trustees' investment decisions.

It states that financial factors are those which affect trustees’ primary duty, to balance risk and return.

This could be interpreted as climate change being a non-financial factor and has hindered trustees from incorporating ESG risks such as climate change into their portfolios, explained Paul Lee, head of Stewardship and Responsible Investment at Redington.

While the Law Commission guidance permits investment decisions based on non-financial factors, they should at least be motivated by other (non-financial) concerns, such as improving members’ quality of life or showing disapproval of certain industries. 

However, the latest FMLC  interpretation goes beyond that, Lee said.

"As long as pension fund trustees approach climate change (and other sustainability) factors in a financial way – meaning on the basis of investment risk and return, in the context of the pension fund portfolio as a whole – doing so is entirely consistent with their fiduciary duties" he argued.

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The FMLC paper goes even further, stating that failing to incorporate climate change as a material risk factor could be in breach of their fiduciary duty, Lee adds.

Moreover, the FMLC paper acknowledges that current legislation may not get capture the full scope of the climate crisis and highlights that our understanding of the financial risks and returns of the climate crisis is likely to develop.

It also addresses the question that some impact or climate investments may offer lower returns than other comparable assets. This would have been a question at the forefront of trustees' mind last year when many fossil fuel producers booked record profits and climate tilted funds comparatively underperformed.

The FMLC paper stated that trustees could still consider the climate friendlier assets as “both financial return and risk would be the considerations, and at the level of the investment, at a portfolio level, and at the level of whole economies material to the pension fund.”

Far reaching impact

Maria Nazarova-Doyle, global head of Sustainable Investment at IFM Investors and a member of the FMLC working group argues that advancing the definition of fiduciary duty could have a far reaching impact, not just for the pensions industry but also the real economy.

“Asserting trustees’ duty to take account of climate change and other relevant sustainability factors as financially material, recommending narrative strategy analysis to supplement the traditional quantitative models given the complexity of such systemic issues, and confirming trustees’ reinforcing role in positive improvements in businesses they invest in via stewardship are just some of the highlights of this ground-breaking review. I believe this paper makes an incredibly important contribution to this ongoing debate."

James Alexander, CEO of the UK Sustainable Finance and Investment Association (UKSIF) also welcomed the clarifications as long overdue: " There has been confusion for some time over how far environmental, social, and governance (ESG) risks and opportunities should be considered on behalf of beneficiaries. This guidance sends a clear message that ESG risks, and particularly climate change, present serious financial risks that should be considered by fiduciaries as part of standard investment practice, taking long and short-term investment horizons into account."

Manager and owner alignment

Evolving the interpretation of fiduciary duty in the UK could further highlight the gap between UK asset owners and their managers, which are often based in the US and operate along different notions of fiduciary duty, Lee acknowledged. 

"The Atlantic marks a big divide in the understanding of fiduciary duty – it’s one of those areas where we are tricked by a common language. In the US those words are understood to mean think only about financial returns, and with a narrow understanding of what amounts to financial. As the FMLC paper makes clear, the UK understanding of fiduciary duty (and I think this is consistent with perspectives around Europe) is very much broader than this and properly incorporates all factors (such as those commonly referred to as ESG) that are relevant to investment risk and return across portfolios as a whole and over relevant time horizons for the investment institution and its beneficiaries. So where a UK (or European) asset owner has a US-based fund manager there is already a real danger that they understand fiduciary duty very differently" he warned. 

But Lee also added that asset owners will now have to give clearer instructions to their managers to ensure that their mandates fully incorporate their understanding of climate change’s implications for risk and return. In exchange, managers selling to UK, and indeed European asset owners have a duty to frame these challenges through the perspective of investment risk and return, he argued.